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How does one avoid paying VAT when returning defective products to China?

Posted: 2011-09-30

Full Question

How does one return defective products to China? We have a cooperative supplier, but they say the returned products (a container load) are subject to VAT and customs duties that they cannot afford to pay for. Is there a way to avoid these fees and have the factory repair and return the goods.

Answer

Unfortunately, you have discovered one the biggest headaches in China sourcing.

For your reference, a Chinese friend of mine who worked at the port in the customs office told me the Chinese government was concerned that if they allowed defective merchandise to be returned to China duty free, some companies would take advantage by declaring legit imports defective in order to avoid paying the tax.

Regardless of the reasons, the system in China is designed to make it very hard to return defective goods, even if the overseas buyer has a clear paper trail and full support of the original supplier.

As far as I know, there is no official channel for sending back goods and avoiding VAT and duties as they cross back into China. Adding insult to injury, the goods may be subject to China outbound taxes again when the re-shipment takes place. Inbound US duties/taxes may also apply when the re-shipped goods arrive in USA.

Did I just hear you scream in frustration? Don't give up just yet, I have some ideas for you.

While it is not a solution to your current problem, for future orders keep in mind that companies like AQF (http://www.asiaqualityfocus.com/) can conduct independent audits and inspections for only a few hundred US dollars, so you can check the quality of your orders before the goods clear outbound China customs.

Another good idea for the future is to have clear terms in your contracts about how to handle defective merchandise. If you need support in that area, let me know and I'll be happy to introduce local English-speaking lawyers that can help draft terms for Chinese suppliers. I can also recommend providers of vendor coordination that can do 100% QC before goods leave China, if you need additional support.

But those ideas are to help in the future, what to do now with this container is the big question at hand. Here are some of the solutions that I have used during my 12 years in China when I found problems after the goods have cleared China. First step is to clearly define the following costs:
  • How much will it cost for the supplier to replace and ship the defects via a new shipment?
  • Do the defects that have already arrived have any value as scrap or "B" grade goods?
  • How much will it cost for you to fix the defective items (if possible) in the US?


With those numbers on hand for reference, here's a range of options. I hope one helps you.
  • Send the defects back. The supplier gives you credit on a future order and they eat the cost to return, rework and replace. Be very careful that this supplier will be around to complete the transaction and that you have a lot of leverage and history together. I have seen more than a few suppliers simply pass on ever doing business with the client again rather than do what is right and replace the goods.
  • Rework the goods in the USA with local technicians or ones sent from China.
  • Send the goods to Hong Kong and have the re-work take place there. Labor and warehouse is much more costly than in PRC, but still much less than USA. Most important, HK is more flexible with the duties.
  • Once the goods are in HK, you could also arrange for a "gray shipment" to PRC for re-work. Don't try to arrange it under your name; there are third parties who will leverage their relationships with boarder officials to bring your product into China at a reduced tax rate. This is very much a "gray area" practice, but very common nonetheless. Often, the third party will reclassify your goods under an HS code that is not taxed at importation. The reason I suggest you ship to HK first is that it is very hard for these third parties to arrange a "special channel" for international freight, but the HK-Shenzhen boarder is much more porous and things are flexible since trucks cross back and forth overland. As this is not black and white, your supplier may not have experience either, especially if they are not based in China near HK. So if you do explore this gray area, make sure you deal with a firm that does have experience and be sure to structure your payments so that they get paid AFTER the delivery is made.
  • If all else fails and your supplier isn't stepping up to the plate to fix the problems or saying "they can't afford to fix it," know that I have had many suppliers "suddenly" come up with the cash once a lawsuit was pending. Check out the blog post I wrote last month if you want to learn more about your options ("Resolving a dispute: Demand letters and legal options"). Keep in mind that in China you can sue for lost revenue. Since you probably were expecting to add a healthy margin when you sold the goods to your clients, this lost revenue is a big stick you can use as leverage over your supplier. If you want to read up on my experience with the courts in China, do a key word search at >www.ChinaSourcingInfo.org of "court", "legal" or "lawsuit" and you will find a bunch of my blog posts on this subject.

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